Auditing by the Defense Contract Audit Agency (“DCAA”) is a ubiquitous cost of doing business with the Department of Defense, and one which many defense contractors have come to dread. Unfortunately, far too often the DCAA’s audit reports rely upon faulty evidence and/or unreasonable interpretations that ignore the plain language of contracts, procurement regulations, and existing decisional law. When this happens, contractors typically have no choice but to engage in the costly process of challenging the audit findings and, when contracting officers lack the will to butt heads with the DCAA, to pursue litigation (and incur unallowable costs) to obtain relief from noncompliance determinations that never should have issued in the first place.

Last year alone witnessed at least two cases involving DCAA audit reports that were questionable at best but still necessitated litigation before the Armed Services Board of Contract Appeals (the “ASBCA”). In the first of these cases, Lockheed Martin Integrated Systems, Inc., ASBCA Nos. 59508, 59509, 17-1 BCA ¶ 36,597, the Government’s entire legal theory on appeal originated with a DCAA audit report that found the contractor noncompliant with FAR 42.202(e)(2)’s requirement that a prime contractor manage its subcontractors. According to the DCAA audit report, which the DCAA claimed was based in part on “[a] literal interpretation of FAR 42.202,” the contractor violated the requirement to manage its subcontractors by not maintaining certain substantiating documents of its subcontractors for an incurred cost audit and for not initiating audits of its subcontractors’ incurred costs. On appeal, the ASBCA ruled that there simply was no contract term, either express or implied, giving rise to an obligation for the contractor to manage its subcontractors in the way the DCAA audit report described. Thus, far from supporting the DCAA’s “literal interpretation,” the ASBCA ruled that, because the only basis for finding the contractor noncompliant was the contractor’s “breach” of non-existent duties, the Government could not proceed on its claim against the contractor.

Another erroneous DCAA audit report was at the heart of A-T Solutions, Inc., ASBCA No. 59338, 17-1 BCA ¶ 36,655. In that case, the Government refused to pay catalog prices for training materials because a DCAA audit report found that the contractor’s interorganizational transfers occurred at cost instead of at price as required under FAR 31.205-26(e)(1). On appeal, the ASBCA ruled against the Government, finding that it could not refute the contractor’s credible evidence that such transfers were recorded by the transferring division at commercial catalog price, which evidence included subsidiary records from a sophisticated accounting system that the contractor could not convince the DCAA to review. The Government also attempted to argue on appeal that the contractor’s transfers did not qualify as “interorganizational transfers” under FAR 31.205-26(e)(1) because they lacked “economic substance.” In rejecting this argument, the ASBCA not only held that the Cost Principle does not impose such a requirement, but that even if it did, the evidence presented by the contractor – including the subsidiary records the DCAA refused to review – revealed that the transfers were not mere “physical transfers” lacking economic substance.

As the foregoing demonstrates, defective DCAA audit reports based on clear legal error and the costly litigation they generate are not going away anytime soon. This begs the question then: what can contractors do to recover from the Government the legal costs that result from the DCAA’s defective work product? If the contractor is small enough and the Government’s claim was not substantially justified, the contractor may be able to recover costs under the Equal Access to Justice Act. For larger players, however, the answer appears to be nothing.

In General Dynamics Corp. v. United States, 139 F.3d 1280 (9th Cir. 1998), the infamous “DIVAD” case, the Ninth Circuit held that a contractor could not recover the legal costs it incurred defending against a False Claims Act (“FCA”) claim initiated as the result of a negligently prepared DCAA audit report because the DCAA’s actions were not totally separate from the Department of Justice’s decision to prosecute, thereby falling within the “discretionary function” exception to the Federal Tort Claims Act’s (“FTCA”) waiver of sovereign immunity. Interestingly, and similar to what happened in A-T Solutions, the DIVAD case was spawned by a DCAA audit in which the underlying contract’s “best efforts” terms and conditions were simply ignored by the auditors, resulting not only in civil false claims allegations against the contractor, but in baseless criminal indictments against contractor employees. There were no consequences for the Government or the auditors, and no recourse for the victims of the auditors’ malpractice.

More recently, the Delaware District Court in Kellogg Brown & Root Services, Inc. v. United States, 102 F. Supp. 3d 648 (D. Del. 2015), took the General Dynamics Corp. holding one step further, ruling that, in addition to FCA related legal costs, a contractor could not recover the legal costs it incurred in pursuing an ASBCA noncompliance appeal initiated as a result of a negligently prepared DCAA audit report. In addition to finding that the DCAA’s actions leading to the ASBCA appeal were not totally separate from the contracting officer’s discretionary decision to disallow costs, the District Court went on to hold that the DCAA’s audit itself was a discretionary function because both Generally Accepted Government Auditing Standards and the Defense Contract Audit Manual require DCAA auditors to use “discretionary judgment” when performing audits. Thus, unless the General Dynamics Corp. and KBR decisions are overturned or abrogated, or at the very least rejected by other Circuits, contractors must eat the costs of litigation caused by DCAA audit reports regardless of how carelessly they have been prepared.

Like claims sounding in tort, claims sounding in contract have been almost as futile in recovering damages incurred during an improperly performed government audit. Contractors that have tried to recover damages for an improper government audit on the basis of a breach of the implied covenant of good faith and fair dealing have seen their efforts defeated by the “clear and convincing” proof needed to overcome the presumption of good faith enjoyed by procuring officials, as well as by the broad discretion afforded to procuring officials by the courts and boards. Indeed, the kind of extreme behavior needed to show that the Government breached the covenant of good faith and fair dealing is illustrated in one of the few cases in which such a claim succeeded – North Star Alaska Housing Corp. v. United States, 76 Fed. Cl. 158 (2007). In that case, the Court of Federal Claims found such a breach when a contracting officer had abdicated his responsibility to make independent decisions by bowing to pressure from other officials to initiate an audit for fraud that was motivated by the officials’ desire to use the wheels of Government to grind down the contractor for its failure to comply with their interpretation of a lease. Thus, given the high degree of governmental fault needed to breach the implied covenant of good faith and fair dealing, the Government has little reason to worry that its audits will result in contract damages.

Let’s contrast this insulation of the Government from the consequences of its administrative negligence with how the FAR treats a similarly situated contractor. Leaving aside the propensity of the Government to claim “reckless disregard” and launch a false claims proceeding when contractors make mistakes, the FAR imposes monetary penalties for the inclusion of “expressly unallowable costs” in annual indirect cost submissions or for including costs previously determined to be unallowable. FAR 42.709-1. The penalties range from the value of the costs disallowed plus interest to twice that amount. A fair system would apply this approach in reverse – an audit basing a proposed disallowance on interpretations of the Cost Principles or the Cost Accounting Standards that previously have been rejected by the courts or boards would penalize the Government by an amount equal to two times the costs incurred to challenge and correct the auditors’ malpractice. Adopting this approach in the FAR, and creating a contractual right to recompense, would avoid the “discretionary function” / “discretionary judgment” bars erected in General Dynamics and KBR and impose a duty of care on the auditors that would constrain the kind of reckless audit postures reflected in Lockheed Martin and A-T Solutions. And the FAR Council will entertain such a regulatory proposal on the first Monday in October after hell freezes over.

Conclusion

For reasons explained in a prior posting, click here, erroneous DCAA audit reports will continue to issue. And they will continue to issue free of concern for legal consequences to the Government institutionally or to the audit team as individuals. Nonetheless, the extent to which errors permeate DCAA audit reports counsels contractors to question and scrutinize audit reports and challenge them early in the process, before the disputes process takes root.

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